As I covered in my post on diversification last week, data shows that the chance of finding a long-term winning stock is only around 7%.
With this being the case, it makes sense for most investors to hold a selection of tracker funds in their portfolios, rather than trying to beat the market by picking stocks.
As the odds are heavily stacked against you, what’s the point of putting in the extra time and effort to find winning equities?
Warren Buffett, who is widely believed to be the best investor alive today, thinks that this is the best option for most investors.
In an interview with CNBC earlier this year, Buffett stated that he believes the average investor should “consistently buy an S&P 500 low-cost index fund,” as this “makes the most sense practically all of the time.”
He suggests staying the course, despite market fluctuations. “Keep buying it through thick and thin, and especially through thin,” Buffett declared.
This strategy might seem boring, and lazy at first glance, but there’s a lot of sense in adopting such an approach.
Indeed, I can show you why with just two data sets.
How to Invest to beat the average investor
First, a chart from Richard Bernstein of Richard Bernstein Advisors. The chart below was compiled in 2014 using 20 years of historical data. As you can see, almost every asset class outperformed the Average Investor over this period. Even Hedge Funds, for all their faults, produced an average annual return of around three times more than the average investor.
The second data set comes from Aswath Damodaran, Professor of Finance at the Stern School of Business at New York University. Aswath has compiled the raw data of stock, bond and bill returns from the Federal Reserve database in St. Louis since 1928. The figures show that the S&P 500 has produced an average annualised return of 11.4% between 1928 and 2016.
Data Source: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html
Put simply, these two data sets show: a) it’s unlikely you’re going to be able to beat the market and; b) if you buy the market you could achieve a return three times higher than the average investor.
So, if you want to profit from investing, a low-cost index tracker fund appears to be the best option. Picking stocks or actively managed funds is a time-consuming and challenging business, with no guarantee of market-beating, or even market-matching returns.
That’s not to say that it’s impossible to beat the market, it is if you know how and are prepared to put in the extra effort.
The average investor annual return in the chart above is taken from DALBAR’s Quantitative Analysis of Investor Behavior report, which has been around for 23 years.
The report has found that the overwhelming reason for investor underperformance is emotion. Investment results are more dependent on investor behavior than on fund performance. Investors just can’t resist the temptation to trade in and out of stock/funds, which is holding back performance.
The perfect example of investors’ flightly attitude is the average performance during 2016. For the 12 months ended December 30, 2016, the S&P 500 index produced an impressive annual return of 11.96%, while the average equity mutual fund investor earned only 7.26%, a gap of 4.70 percentage points.
This underperformance is most attributable to January (1.74%) and the “Trump rally” in November (1.13%) and December (1.34%). According to the report, “Investors had to push against media negativism from January to the end of the year. They were largely sellers in the second half of the year, either from fear or an attempt to find the top of the market.”
These attempts to time trading held back gains and, as a result, investors paid with underperformance.
There is a simple way to make sure you avoid the emotional performance drain exhibited in the Dalbar study. Buy the whole market and hold through thick and thin.
This isn’t a glamorous trading strategy. It’s boring and requires no effort at all. However, over the long term, when combined with compounding, the results speak for themselves.
£1,000 compounded at 3% per annum for a decade will become £1,347 while £1,000 compounded at 11.4% for the same period will grow to £3,030.